India: After the shock of demonetisation, growth is firing on all cylinders

Following the slowdown triggered by the abrupt implementation of demonetisation measures and a new Goods and Services Tax (GST), steady growth has returned, exceeding 8% year-on-year in Q2 2018. Consumer spending has continued to provide a basis for growth, and business investment contributed to the recent acceleration in GDP. On the other hand, the trade balance had a slightly negative impact.

So it is not a downturn in the economic outlook that is worrying markets. In contrast, the fact that the Indian economy has for many years borrowed money from the rest of the world to finance its growth is a source of concern for financial market participants. With 5% of GDP in 2013, the current account deficit has substantially shrunk and is now below 2%. Furthermore, it has been primarily financed by direct investment, which is generally more stable and sustainable over time than other sources of financing. The trade risk with the US – its largest trading partner – is also quite limited: India’s trade surplus with the US is only USD 22 billion (vs. over USD 200 billion for China with the US) and exports include mainly IT services and other niche goods such as cut diamonds and medicines.

The non-financial private sector in India is relatively well-positioned to absorb any potential shocks, given that households and companies alike have low levels of debt, and the vast majority of these debts are in Indian rupees.

The public sector situation is, however, more worrying. At 70% of GDP, leverage is high, especially considering that its development is still at a relatively low level. Despite a government deficit of over 6%, India’s high economic growth has kept its public debt burden on a stable trend for the last ten years or so. However, the public debt burden could rise substantially if the government were forced to recapitalise a number of public banks facing increasing difficulties. Public banks account for a very large share of the banking sector and their profitability is deteriorating, with non-performing loans rising sharply (close to 10% of outstanding loans in 2017). Additionally, 25% of loans were granted by non-banking financial institutions. Against a backdrop of tightening financing terms globally, the cost of financing for these institutions is rising, and the payment default of IL&FS, a semi-public institution, has brought to light liquidity issues. If tensions were to persist, access to credit could be reined in, depressing growth. However, the government swiftly seized the initiative, replenishing the coffers of IL&FS, and thus seems determined to avoid any contagion to the financial system as a whole.

Against this background, growth should slow a little but remain above 7% in 2019.